Supermarkets face dollar dilemma: raise food prices for profits? Or keep cheap to compete?

The price hikes iii milk, beef and other food should be good news for supermarkets because they can seize the opportunity to finally pass along those increases to consumers--and tack on a higher profit margin to boot.

But the supermarket business, especially in Southern California, is being pummeled by conflicting forces that may make what used to be automatic price rises more difficult this time around.

The confluence of factors starts with the influence of low-cost merchandisers, such as Wal-Mart Stores Inc. and Costco Wholesale Corp., which show little inclination to raise prices. Add to that the bottom-line pressures of the three major grocery chains as they look to bring back their old customers alter a four-month labor stoppage--and recover from heavy losses.

For the moment, however, the supermarkets appear to be betting that their customers will come back--even if they have to pay more.

Local consumers have seen a 3.8 percent increase in food and beverage prices for the 12-month period ended in April, according to the latest Consumer Price Index released by the Bureau of Labor Statistics. Nationally, food inflation is projected to run this year from 1 percent to 3 percent, the first real increase since 1996.

Consumers in Los Angeles paid an average of $3 for a gallon of milk in March, the most recent data available from the California Department of Food and Agriculture, up from $2.50 for the like period a year earlier. Since the farm gate price (the minimum a farm must be paid for its milk) is also increasing, shoppers can expect to pay more for milk in June, said Steve Lyle, director of public affairs for the California Department of Food and Agriculture. That will lead to likely price hikes for other dairy products.

The price climb is being seen for other food as well; the American Farm Bureau Federation's market basket survey showed prices nationwide in the first quarter were up 6 percent from the previous three months and 10 percent from the first quarter of 2003.

"Historically, inflation has been a positive thing for food stores, particularly in Southern California, which is one of the most competitive retail environments in the nation," said Douglas Christopher, an analyst with Crowell Weedon & Co. in Los Angeles. "They have to raise prices at some point, particularly in California, where we have higher workers' comp, insurance costs and costs for doing business. Higher prices offset already rising costs."

Steven Burd, president and chief executive of Safeway Inc., parent of Vons Co. and the chief architect of the supermarkets' recent labor strategy, suggested as much in a recent conference call. "It's been our practice, and frankly the practice of all the retailers that we compete with, that when you get cost increases, particularly if they're modest, those get passed on," Burd told analysts.

To be sure, lower-price retailers still influence prices, regionally and nationwide," We're not raising prices and we don't intend to," Wal-Mart Chief Executive Lee Scott said in a recent conference call. And while the 12-month CPI increase in the grocery category is approaching 5 percent locally, the April number was down 0.1 percent--partly a reflection of the continued influence of Wal-Mart and Costco, according to Jack Kyser, chief economist of the Los Angeles County Economic Development Corp.

But even the big-box giants, with their vast purchasing power, cannot control everything. As Merrill Lynch analyst Mark Husson recently told the trade publication Supermarket News: "There's no cheap herd of Arkansas cows out there that yield their milk and carcasses for way below market cost. (Wal-Mart) may not be raising prices overall, but in certain commodities they will have to."

There are various explanations for the higher costs, starting with energy. Hormel Foods Corp. cited increased transportation costs in announcing a 4.5 percent price hike for its canned and packaged foods, starting in June. It's the first price increase since 2000. Birds Eye Foods Inc. is raising its prices 5 percent, in part because it must pay more for plastic packaging made from petroleum products.

Also affecting prices are the dynamics of the dairy industry. The market had been so flooded through the late 1990s that prices for milk plummeted in 2002, leading some dairy farmers to pull their cows out of production. Now, with the supply of cows at a five-year low, prices have shot up.

Bill Bishop, a consultant at Willard Bishop Consulting in Barrington, Ill., described rising milk costs as "a major episode in a fairly stormy situation." He added, "We're right on the cusp of a very significant increase in inflation in some food categories. Everyone would agree there's going to be more inflation, it's just a question of how much and when."

Higher beef and poultry prices, meanwhile, are being affected by the higher cost of corn and soybeans. And high-protein diets have increased demand for steaks and other protein.

The scare over mad cow disease has affected beef prices, in turn has caused poultry prices to rise as farmers are forced to pay more for chicken feed due to the banning of ruminants, said Elisa Odabashian, San Francisco-based senior policy analyst for Consumers Union, the non-profit publisher of Consumer Reports.

In general, the supermarket industry is sounding few alarms about the pickup in prices. In fact, some on Wall Street consider this to be a buying opportunity for supermarket stocks because food inflation could lead to higher profit margins and improved earnings.

As for the possible lost business, consumer surveys generally place price well below other reasons, such as convenience, for patronizing a market. That's one reason, some analysts said, that smaller, higher-priced chains like Whole Foods Market Inc., the Gelson's unit of Arden Group Inc. and Bristol Farms have fared well Southern California.

Still, there are those who worry about inflation getting out of hand. Pathmark Stores Inc., a supermarket chain in the Northeast, recently warned of first-quarter losses and same-store sales declines--and cited higher prices for poultry, beef, pork, butter and cheese as a chief reason. "Our inability to pass the full cost increases into retail pricing because of competitive reasons affected gross profit," Chief Executive Eileen Scott said in a conference call.

Even executives at Kroger Co., parent of Ralphs, appear unsure of the ultimate impact Of food inflation.

"It's like a new animal to us," Michael Schlotman, Kroger's senior vice president, told a recent Lehman Bros. investors conference. "The inflation we're seeing now is mostly commodity-based and rather sudden, and it's hard to pass that along."

Then there's the broader economy. Average consumer prices in the Los Angeles, Riverside, San Bernardino, Ventura and Orange county region increased 2.3 percent during the past 12 months. That covers housing, transportation and medical care, as well as food.

"What's more of an issue is that overall inflation is starting to creep into the system," said Christopher Thornberg, senior economist with the UCLA Anderson Forecast. "Incredibly low interest rates have driven mortgages down and consumers have borrowed from tomorrow. When you have inflation in the system, it makes real returns much more difficult."

Showing Cracks

The one-year rise in the price of eggs in the U.S. led
hikes in other food staples.

                                      Price       Price       Percent
Item                                  1Q '03      1Q '04      Change

Eggs (1 dozen)                        $1.22       $1.59          29%
Corn oil (32-oz. bottle)               2.41        3.09          28
Vegetable oil (32-oz. bottle)          2.25        2.76          23
Ground chuck (1 pound)                 2.10        2.48          18
Whole fryers (1 pound)                 1.05        1.24          18
Apples (1 pound)                       1.05        1.22          16
Sirloin tip roast (1 pound)            3.21        3.52          10
Pork chops (1 pound)                   3.10        3.42          10
Cheerios (10-oz. box)                  2.78        3.00           8
All-purpose flour (5-pound bag)        1.53        1.62           6

Source: American Farm Bureau Federation